Scenario Testing

Scenario testing allows a credit union to assess a range of alternative or potential interest rate scenarios. There are multiple scenario types.

In a rate shock scenario, parallel rate changes are immediate and sustained. For example, in a plus 300 basis point rise scenario, the full effect of the rate increase would be for all points along the yield curve.
In a yield curve test, changes in the shape or slope of the yield curve are imposed, such as a steepening or flattening scenario run from the current term structure.
In a rate ramp scenario, rate changes are applied gradually over a period. For example, when measuring the effects of a 300 basis point rate increase during a 12-month period, rates could be increased 25 basis points each month.
In a stair step scenario, rate changes are at less frequent intervals over a period. For example, in a 300 basis point increasing rate environment stepped up over a two-year period, rates may be increased 50 basis points each quarter of the first year and 25 basis points each quarter of the second year.
In a basis risk scenario test, changes are applied in the relationships between key market rates for concentrations of assets with basis risk.

Not all credit unions need to use the full range of the scenarios listed above. Credit unions with non-complex cash flows (with limited embedded options or structured products) may be able to justify running fewer or less intricate scenarios. Also, not all alternative tests need to be run with the same frequency as those tests which serve as policy limits. Credit unions can adjust the frequency of alternative scenarios based upon their understanding of their inherent sensitivities revealed in prior results.

Management should run repricing, basis, and yield curve risk scenarios regularly. Credit unions should assess these risk scenarios at least annually or when the risk profile changes for new products. If the testing shows a material exposure to one of these risks, the credit union should consider a more regular schedule to assess the risk and should include this in monthly or quarterly IRR monitoring. If a credit union has relatively non-complex risks to basis, yield curve, or option risk, the examiner should document that the risks are minimal.

Another example of a possible extreme stress scenario would be when interest rates are low. Credit unions should consider negative interest rate scenarios and the possibility of asymmetrical effects of negative interest rates on their assets and liabilities. The absence of history and empirical information about negative interest rates makes it difficult to forecast the potential effects of this scenario. To the extent that the term structure of interest rates trends toward lower and even negative levels, credit unions may need to begin researching and developing assumptions to forecast the potential impact on share behavior and how to handle the pricing of assets and liabilities.

An important trait of effective risk management is ongoing monitoring and effectively responding to IRR measures. Credit unions that use risk measurement information to make business decisions, whether it be purchases, sales, or another kind of risk mitigation (such as hedging), are more likely to optimize their net worth and earnings performance over time.

Last updated on December 06, 2024